Relevant cost concepts

Decision making involves making a choice between two or more alternatives. The decision will be rational; profit maximising. All decisions will be made using relevant costs and revenues.

DEFINITION; Relevant costs are future cash flows arising as a direct consequence of the decision under consideration.

Opportunity Cost
An opportunity cost is the value of the best alternative that is foregone when a particular course of action is undertaken. It emphasises that decisions are concerned with choices and that by choosing one plan there may well be sacrifices elsewhere in the business.

Example 1 OPPORTUNITY COST

A company which manufactures and sells one single product is currently operating at 85% of full capacity, producing 102,000 units per month. The current total monthly costs of production amount to $330,000, of which $75,000 are fixed and are expected to remain unchanged for all levels of activity up to full capacity. A new potential customer has expressed interest in taking regular monthly delivery of 12,000 units at a price of $2.80 per unit. All existing production is sold each month at a price of $3.25 per unit. If the new business is accepted, existing sales are expected to fall by 2 units for every 15 units sold to the new customer. What is the overall increase in monthly profit which would result from accepting the new business?

The relevant cost of labour

If labour hours are required to carry out a piece of work, the relevant cost of their time will depend upon the circumstances. There are generally 3 situations that arise;

There is spare capacity and the salaried staff are paid anyway. o Relevant cost is zero The staff are working to their contracted hours, but additional hours can be obtained, for example overtime or by hiring additional staff. o Relevant cost is the direct labour cost Staff are fully utilised on existing work, and no additional hours can be obtained o Relevant cost is the direct labour cost PLUS contribution foregone
Always remember to apply basic logic, consider relevant cash flows and then use a bit of common sense!

Example 2 RELEVANT COST OF LABOUR

100 hours of skilled labour are needed for a special contract. The staff are working at full capacity at the moment and the workers would have to be taken off production of Product Y in order to work on the special contract. No additional labour hours can be obtained and staff will not work overtime. The details of the other product are shown below: $/unit Selling price Direct material Direct labour 1 hour @ $10/hour Variable overheads Contribution per unit 60 (10) (10) (15) 25

The skilled workers pay rate would not change, regardless of which product they worked on. What is the relevant cost of labour if the special contract is undertaken?

Example 3 CONTRIBUTION PER HOUR

100 hours of skilled labour are needed for a special contract. The staff are working at full capacity at the moment and the workers would have to be taken off production of Product Z in order to work on the special contract. No additional labour hours can be obtained and staff will not work overtime. Product Z generates a contribution of $80 per unit and requires 2 labour hours per unit. The labour rate is $15 per hour. The skilled workers pay rate would not change, regardless of which product they worked on. What is the relevant cost of labour if the special contract is undertaken?

Make or Buy decision

Businesses may be faced with the decision whether to make a basic component for themselves or whether to obtain the component from outside suppliers. When evaluating this type of decision simply compare the relevant cost of buying in the component with the cost of manufacturing the component inhouse. If the component is to be made in-house, consider carefully the relevant cost of the resources that are required; - Look for incremental (marginal) cash flows arising as a direct consequence of this decision - If scarce resources are to be used on making the component, watch out for any opportunity costs

Example 4 RELEVANT COST OF AN ORDER

A company manufactures two models of a pocket calculator; the BASIC model sells for $5.50, has a direct material cost of $1.25 and requires 0.25 hours of labour time to produce. The other model, the SCIENTIST, sells for $7.50, has a direct material cost of $1.65 and takes 0.375 hours to produce. Labour, which is paid at the rate of $6 per hour, is currently very scarce, whilst demand for the companys calculators is heavy. The company is currently producing 8,000 of the basic model and 4,000 of the scientist model per month. An overseas customer has offered the company a contract, worth $35,000, for a number of calculators made to its requirements. The estimating department has ascertained the following facts in respect of the work: The labour time for the contract would be 1,200 hours. The material cost would be $9,000 plus the cost of a particular component not normally used in the companys models. These components could be purchased from a supplier for $2,500 or, alternatively, they could be made internally for a material cost of $1,000 and an additional labour time of 150 hours.

Required; Advise the management on the action they should take.